Fear among IFAs that they will get the blame if hedge funds do not deliver is stopping the sector from developing.
While product providers argue that funds of hedge funds are safe products offering suitable diversification within a balanced portfolio, IFAs are steering clear because they do not want to be held responsible for failing investments.
They also claim that many people do not understand how hedge funds work and will not invest in them because they are unregulated.
Hedge funds are exempt from many of the rules and regulations governing other mutual funds, which allows them to accomplish aggressive investing goals using strategies such as selling short, leveraging, programme trading, swaps, arbitrage and derivatives.
As with traditional mutual funds, investors in hedge funds pay a management fee. However, hedge funds also collect a percentage of the profits.
The FSA currently bans the marketing and sale of hedge funds to retail investors except in certain circumstances but it does regulate hedge funds managers that are based in the UK.
Around 18 months ago, the FSA issued a discussion paper on hedge funds but the result was that it opted to maintain the status quo but review the situation.
In a speech at an asset management conference in London last week, FSA managing director (wholesale and institutional markets) Hector Sants signalled that the regulator may be ready to look again at whether hedge funds are appropriate for retail investors.
Funds of hedge funds offer diversified access to hedge funds and providers agree that these are the most suitable vehicle for retail investors.
The key performance assumptions for each manager building a fund of hedge funds are return, risk and correlation. Providers argue that assessing these closely and monitoring risk policies of individual managers and of the whole portfolio means that comprehensive risk management can be put in place.
IFAs who do choose to use hedge funds generally ensure that the provider has a diverse database of hedge fund managers, the infrastructure to maintain this and the ability to perform ongoing due diligence on all the managers.
But Hargreaves Lansdown head of investment research Mark Dampier thinks traditionally high charges would still be offputting to most IFAs.
As an example, Close Fund Management has a hedge fund open to retail money. The guaranteed hedge fund II has targeted annualised returns of 11 to 13 per cent over the medium term, a prediction that is net of any initial commission.
It requires a minimum investment of £10,000 and an investment term of around eight-and-a-half years. There is initial commission of 3 per cent, with 0.4 per cent trail, and an annual management charge of 1.65 per cent which includes a 0.25 per cent guarantee fee and 0.4 per cent trail.
Dampier says: “The charges can sometimes eat into the return of the fund. A lot of people seem to talk about hedge funds like the alchemist turning lead into gold and the answer to everyone's problems. But IFAs do not know well enough how they work.
“We are not talking about them and because of that clients are not asking about them. An added problem is the lack of clarity of regulation. Too often it seems like it is the intermediary that is punished if there is a problem and the provider never seems to be answerable.
“Hedge funds have performed very well but they do rely on a certain amount of volatility and that has not been there in the last few years. The returns of 15 per cent that we were seeing are just pie in the sky now.
“Hedge funds have taken advantage of small anomalies in the market and, with more and more hedge funds out there and more managers searching for them, these small anomalies are drying up.”
Fund managers would welcome the regulation of hedge funds, believing it would make them more accessible to the retail investors.
Recent research from NMG shows that those IFAs who have recommended hedge funds have done so in the belief that they reduce volatility and because investors have been stung by the poor performance of traditional equities.
A fifth of IFAs choosing hedge funds have opted for a single manager while more than a third are selecting multi-manager single-style portfolios and a further 42 per cent going for multi-manager multi-style portfolios.
According to Close Fund Management managing director Marc Gordon, the multi-manager style hedge funds are more risk-adjusted and therefore good choices for anyone who wants to build stability into a portfolio. He also believes the high charges are justified since “quality work is worth paying for”.
Gordon says: “Hedge funds are about producing high returns in all market conditions and producing returns that are risk-adjusted. The IFA can diversify his own risk by building in a multi-manager portfolio of hedge funds.
“Hedge funds need to be clear and what they are doing needs to be understood by investors. I would not envisage any problems with them as long as they are doing what they say on the tin.”
The fact that the FSA is starting to look again at hedge funds is a signal that it recognises there could be something there for retail investors. With time, the asset class could become increasingly mainstream.